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October
31
2023

A rising wave of property defaults threatens hundreds of US banks
Ambrose Evans-Pritchard

Vulnerable lenders are being squeezed on all sides as a debt-laden real estate sector succumbs to hybrid working

America’s commercial property collapse is becoming a danger to the financial system.

Office blocks purchased with debt remain half empty, 18 months after the end of the pandemic. Thousands of buildings will have to be torn down. Hundreds of regional banks are sitting on crippling losses that they yet to acknowledge.

“It’s a trainwreck in slow motion,” said Professor Stijn Van Nieuwerburgh, a property and finance expert at Columbia University.

“The return to the office isn’t happening. Data from turnstile swipes shows that occupancy levels are still just 49pc of where they used to be. It has been stable for a year and a half,” he said. Sensors tracking physical presence in offices tell the same story. Hybrid work is here to stay.

Lenders are still gambling on resurrection, a reflex of ‘extend and pretend’ in the hope that office rents will recover and that struggling borrowers will be able to service their debts again. “Banks would do better to bite the bullet now because losses are going to be much worse in two years,” Prof Van Nieuwerburgh said.

His team calculates that America’s office stock has lost 40pc to 45pc of its pre-Covid value, or will have once market discovery exposes the damage already in the pipeline from two parallel shocks: shrinking rents and the most aggressive monetary tightening of modern times.

“We are starting to see distressed sales every day. Offices are selling for 50pc, 60pc or 70pc discounts. At these values the equity holders are wiped out, and lenders take a 30pc loss,” he said.

Renters are walking away or taking less space as leases come due. Average office rents have already dropped by 20pc. Yet two-thirds of the leases have not yet come up for renegotiation. The full exodus has yet to happen.

“We’re in the early innings. That’s the reality,” said Scott Rechler, head of real estate specialists RXR and a board member of the New York Fed.

US commercial real estate has $5.5 trillion (£4.5 trillion) of debts. The worst trouble is in office buildings, though prime assets in hot spots have avoided the broader bloodbath. Projects that made sense in the QE world of free money are no longer viable in the new world of 5pc bond yields.

“The entire commercial real estate space is going through this interest rate regime change. It all has to be reset,”  said Mr Rechler, in a Goldman Sachs exchange.

“Lenders are starting to capitulate, realising that they need to mark down loans. This is going to pick up momentum as we go into 2024.

“Pain will be felt across the board. In the office space we’re already recapitalising loans at 50 cents on the dollar: the equity is wiped out and half of the loan wiped out,” he said.

Prof Van Nieuwerburgh said it is no longer possible to hide the scale of the problem. “$1 trillion of commercial property debt is coming due over the next year and a bit. The average fixed loan is 10 years so the debt maturing today was taken out in 2013 at around 3.5pc. It has to be refinanced at over 7.5pc,” he said.

If you can get a loan. Banks are being forced to slash exposure by shareholders, boards, and regulators. “They’re not actively lending any more. They’re only lending to their best customers,” said Mr Rechler.

The failure of Silicon Valley Bank (SVB) and two smaller lenders in March may only be the first phase of a long dragging crisis in the regional banking system. “I wouldn’t be surprised two years from now if there were 500 to 1000 fewer banks. I’m not saying they’ll go out of business, but there will be heavy consolidation,” he said.

The Fed has staunched the liquidity crisis since March with emergency lending but that buys only time. It does not tackle the deeper solvency crisis.

Prof Van Nieuwerburgh said vulnerable banks are being squeezed from all sides. They are having to lift interest rates drastically to stop deposit flight to money market funds or Treasury notes. Their bond portfolios are trading at a large paper loss, which become real losses if they are forced to crystallise them, the fate that befell SVB. Revenues are flat on good real estate loans. Developers are throwing in the keys on bad loans.

“There are a lot of skeletons in the closet and I wouldn’t be surprised if another 200 small banks topple over. In fact, I fully expect another bank to fail at any time,” said Prof Van Nieuwerburgh.

“Interest rates are even higher now than they were in March. The mark-to-market losses on securities are even worse,” he said.

Banks hold $2.7 trillion of commercial real estate debt. Two-thirds is concentrated among the small and mid-sized regional banks. Exposure among local lenders with assets below $10bn is 280pc of their capital. It is 180pc for sub-tier banks up to $250bn.

“It doesn’t take a big loss to wipe out equity. Fed officials are very worried about this, and they’re sending in supervisory teams to look at small banks,” he said.

“This shock is not happening in isolation. Everything is repricing. All sorts of corporate loans are going to have difficulty refinancing. Credit standards today are about the same as they were at the height of the global financial crisis,” he said.

The likely losses are as large as the $1.2 trillion meltdown of subprime and Alt-A property securities that set off the banking collapse on both sides of the Atlantic in 2008. But this episode has a different character.

Today’s losses are not concentrated in a clutch of ultra-leveraged mega banks. They are spread wider. The process is slower. There is less risk of a chain reaction and a Lehmanesque vortex of doom. It is akin to the savings and loan crisis in the late 1980s, which led to the failure of 747 thrifts but never slipped out of control. But it would be courting fate to count on that.

“If a couple of hundred banks get into trouble at the same time and there is another run on deposits, this could turn into a systemic crisis. There are some parallels with 2008,” he said.

Monetary tightening hits the economy with a long lag. The San Francisco Fed calculates that the proxy Fed funds rate has reached 7pc if you include bond sales (QT). The US money supply is in free fall and this has better predictive power than booming GDP growth in the third quarter.

Has the Fed miscalculated and pushed rate rises beyond the therapeutic dose? History will judge.

Prof Van Nieuwerburgh said some offices can be turned into gyms, clinics or play schools, but that market has limits. Only a fraction can be turned into homes. This requires re-zoning permits, windows that open, lots of stairways and new plumbing.

It is not profitable to convert them until the price of building has crashed to clearance levels, by which time the damage has spread to creditors. The quickest and cheapest solution is often demolition.

America’s developers and lenders have been unlucky. They are not guilty of grotesque overbuilding or Ponzi financing as in China. Nobody could have predicted the pandemic and the hybrid work revolution.

But that does not make it any less painful. “Somebody has to lose their shirt,” said Prof Van Nieuwerburgh.

 

 

Ambrose Evans-Pritchard is World Economy Editor of The Daily Telegraph. He has covered world politics and economics for 30 years, based in Europe, the US, and Latin America. He joined the Telegraph in 1991, serving as Washington correspondent and later Europe correspondent in Brussels.

 

 

www.telegraph.co.uk